Monday, October 30, 2006

Mathematical Illusion: Why Dollar-Cost Averaging Does Not Work

Mathematical Illusion: FPA Journal - Why Dollar-Cost Averaging Does Not Work:

"This paper examined the behavior of stock volatility, which has given rise through illustrations to the widespread belief that dollar-cost averaging allows more shares to be bought over time than would occur through a lump-sum investment. We have exposed that illustration as a mathematical illusion, based on arithmetic changes in a denominator leading to disproportionate changes in the fraction. We found instead that the price variations that would be expected for fundamentally valued stocks is precisely the pattern that negates the advantage DCA commonly has been illustrated to hold. This result has been confirmed by an examination of the performance of a broad number of stocks, adjusted for the impact of trends on the DCA versus LS outcome. Whether DCA is practiced by investors should be based on their psychological makeup (for example, aversion to regret) and their outlook for stocks, not on an overly simplistic and misleading representation of how stock prices vary."

Ok, if the above paragraphed was too confusing (this is an academic journal), here is the basic synopsis - Dollar Cost Averaging does not lead to higher returns, it is a risk management tool that attempts to avoid drastic downturns immediately after investing one's money - it spreads the risk out. Dollar Cost Averaging doesn't work to increase returns over the long term though - the reason - the market on average, goes up over the long term and you are investing your money and higher and higher prices.

Scott Dauenhauer, CFP, MSFP